Nvidia's Core May Be Strong, But Tegra Is Getting Expensive

Nvidia (Nasdaq:NVDA) generates a healthy amount of free cash flow and has maintained a strong GPU business despite but the pressures in the PC market, but analysts and investors have increasingly soured on the company's mobile ambitions. Tegra has yet to catch on, and with competition ramping up from Intel (Nasdaq:INTC), Qualcomm (Nasdaq:QCOM), Marvell (Nasdaq:MVRL), and others, this whole adventure may end up as little more than an expensive mistake. The shares don't look expensive even on undemanding assumptions, but Tegra-related concerns are likely to keep a lot of investors out of the shares.

Decent Second Quarter Earnings
All things considered, Nvidia didn't have a bad fiscal second quarter. Revenue fell 6% from the year-ago period, but was more or less in line with expectations. Revenue from the GPU business rose 8% from last year and 9% sequentially, while the company saw a sharp trailing off of Tegra (down 71% and 49%, respectively).

With more of the revenue mix in the higher-margin GPU business, Nvidia's gross margin came in strong relative to expectation, rising four points on a GAAP basis (or 150bp sequentially). Operating income was down 25% from last year, but still came in about 15% higher than expected despite an 18% increase in R&D spending.

Tegra Upside Seems To Be Vanishing Quickly
Nvidia management has talked a good game on Tegra for quite a while, but they have yet to get a large portion of the sell-side to buy into the story. This quarter's guidance won't help. With updated guidance, it sounds like Tegra is going to be down about 30% year-over-year (versus prior guidance of flat revenue), with tablet and phone-related revenue down considerably more.

Worse still, it's getting harder to find the near-term upside to the program. Nvidia seems to be losing sockets to Qualcomm, and both Intel and Marvell are likely to get VoLTE solutions qualified by the end of the second half of 2013. While I suppose Tegra could see some traction or upside in areas like automotive (Audi and Tesla are already Nvidia users), it's hard to see any sort of near-term payoff coming from the large sums Nvidia continues to spend on R&D.

I also have to question the company's GPU IP licensing strategy. While Qualcomm has managed to create a side-by-side licensing and chip production model, it's harder to see the argument for companies like Apple (Nasdaq:AAPL) agreeing to license Nvidia's technology. On the other hand, if this is a prelude to the company abandoning its ambitions in producing SoCs, the Street would respond positively.

Opportunity Coming At A Cost
I can appreciate why Nvidia feels the pressure to grow its addressable markets – Wall Street is always a “what have you done for me lately?” sort of place. So even though I think assumptions that the PC market is doomed to vanish are very much premature, and Nvidia has an under-appreciated high-performance computing business, I understand the desire to take on new markets.

The trouble is the amount of money that management is committing to these new opportunities. What I see is a slowing high-end mobile device market and fierce competitors like Qualcomm, Intel, Marvell, and Broadcom (Nasdaq:BRCM) fighting for this slowing market. Maybe there's still an opportunity for Nvidia to stand out with a high-performance product, but my concern is that Nvidia is chasing a low-potential market and wasting the cash flow that strong GPU business creates.

The Bottom Line
Even with modest long-term growth forecasts (3% revenue growth, 5% free cash flow growth), Nvidia looks underpriced with a fair value in the high teens. Likewise, the company's return on equity suggests meaningful upside to the company's P/BV ratio. While these shares may be cheap, they're cheap for a reason given that the Street presently expects all of this spending on Tegra to basically be a waste of resources. That view may be short-sighted but absent more confidence in the outlook for Tegra, these shares may have a hard time attracting much support.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.